Some Notes On P/E Ratios Investors Should Never Forget

P/E Ratios and Debt

P/E ratios are an investor’s best friend when it comes to valuing a company, but what is debt’s relationship to a p/e ratio? Companies that have more debt tend to have lower p/e ratios, making them look like they have lower valuations while in reality, they just have more debt. This is because debt does not directly influence the market cap of a company, but still adds on to the total net worth of a company. Debt is basically just cash for a company, but doesn’t affect the market cap of the company. You never hear something like “Apple incurs fifty billion dollars worth of debt, shares soar ten percent”. Never blindly assume that a company has a low p/e ratio because it is undervalued, rather, take a look at the debt level, and if the company has an exceptionally high amount of debt relative to its market cap, then that might be the reason for the low p/e ratio, not undervaluation.

P/E Ratios and Non-Recurring Activities

When a company sells part of its business, the earnings for that quarter becomes artificially higher, since it earned money from selling some of its operations. This is not true earnings, however, and can make the P/E ratio look like it is low, while in reality it is not. A good way to look past this is to also look at the projected or forward P/E ratio, based on analyst projections for next year’s net income for the company, since that would not include the non-recurring selling of operations that is influencing the trailing P/E ratio.

P/E Ratios and Growth Prospects

Companies with high growth prospects tend to trade at higher P/E ratios. This is because investors are willing to pay a premium for the company they want to invest in, since they know it has potential to go up very fast in the future. This way, while net income (“E” in “P/E ratio”) may be low, investors are predicting that the net income is going to appreciate considerably in the future, resulting in a more normal P/E ratio. For example, if a company with a $1 billion market cap has high growth prospects for the future, and its current net income is $10 million, then its P/E ratio is 100. While that is considerably high in the current market conditions, the share of many technology companies commonly traded at those ranges in the 2000 tech bubble. Anyways, even though the P/E ratio is currently high, if investors believe the company has enough potential to earn $50 million annually in the future, then they are willing to pay the premium on the P/E ratio, since the new P/E ratio with the $50 million net income is just 20, a very controllable size. On top of this, those investors would earn from the upwards share price movements in the stock when it grows its earnings throughout the time period.

P/E Ratios and Investor Greed

Also note, however, that while earnings move upward, share price will too, and the share price will drive up the market cap of the company (“P” in “P/E ratio”). This in turn makes the P/E ratio remain at its high levels if the two numbers grow at the same rate. Unfortunately, no matter how fast the earnings of the company grows, it always seems to be the share price that grows faster, constituting an even higher P/E ratio, as investors expect the company to continue growing earnings at hyper-fast speeds in the future. In the end, many growth companies end at a place of extreme overvaluation and end up tanking, like technology companies in the 2000 crash. Investors should pay careful attention to the growth companies they buy, and use the P/E ratio to determine how much earnings would have to grow to get back into an area of fair price, while keeping in mind that market cap and share price will likely increase at the same time as well.

P/E ratios are an incredibly useful tool on the stock market, but they can be distorted in many ways. Investors need to be aware of these distortions and the causes of them, and therefore understand the true value of their equity holdings to the fullest extent.

A Short Explanation of Market Cap

This explanation of what market cap is will help readers of my blog figure out what most of my undervalued plays are and why they are undervalued. Market cap is a basic valuation of a company used to determine what a company is worth. Market cap equals share price * shares outstanding. Share price is simply the cost of a stock’s shares, while shares outstanding is the total amount of shares of a stock out on the market. Therefore, there are two ways of changing a company’s market cap: increasing or decreasing the share price of the company, which happens to a company every trading day, or increasing or decreasing the shares outstanding of a company. Companies rarely increase their shares outstanding by issuing out new stock, but will often buy back their own stock if they have extra cash on hand. In a share buyback program, a company will take a specified amount of money and buy their own stock on the market in a specified amount of days. This is meant to decrease the shares outstanding and increase the earnings per share (EPS) number, so that for every dollar a company earns, you earn a bit more than you did before. When I call a company undervalued on my blog,  I am predicting that the market cap of a company will increase, that is, the value of the company will go higher, because the share price will increase.  Therefore, if a company has a market cap of 10 billion and it is undervalued by 5 billion, the share price is expected to move 50% higher in order to increase the market cap to 15 billion.